Second Circuit Affirms Enforceability of Flip Provisions in Swap Agreements Under Bankruptcy Code Safe Harbor

For over a decade, Lehman Brothers Special Financing (“LBSF”) has been litigating the enforceability of so-called “flip clauses” in connection with the post-bankruptcy liquidation of swap agreements. These clauses, which are common in structured financing transactions, specify the priority of payments when a swap provider (like LBSF) is in default. In particular, these clauses purport to subordinate the swap provider’s payment priority below that of noteholders when termination payments are owed due to the provider’s default.

When LBSF’s holding company (Lehman Brothers Holdings Inc.) filed a chapter 11 petition in September 2008, that filing placed LBSF in default under various swap agreements to which LBSF was a party. In a 2010 complaint involving 44 synthetic collateralized debt obligations (“CDOs”) that LBSF created, LBSF sought to claw back over $1 billion that had been distributed to noteholders in connection with the early termination of swap transactions, arguing that the flip clauses in those transactions were ipso facto provisions and therefore unenforceable. (Ipso facto clauses are contractual provisions that modify a debtor’s contractual rights solely because it petitioned for bankruptcy; the Bankruptcy Code generally treats such provisions as unenforceable.) The noteholders defended the distributions on various grounds, including by invoking the safe harbor codified in section 560 of the Bankruptcy Code, which exempts “swap agreements” from the Bankruptcy Code’s prohibition of ipso facto clauses.^[1]

In two earlier cases involving similar CDOs, the judge originally presiding over Lehman’s bankruptcy (Bankruptcy Judge James M. Peck) had treated the flip provisions as unenforceable ipso facto clauses and deemed them to fall outside of the section 560 safe harbor. See Lehman Bros. Holdings Inc. v. BNY Corp. Tr. Servs. Ltd., 422 B.R. 407 (Bankr. S.D.N.Y. 2010); Lehman Bros. Special Fin. Inc. v. Ballyrock ABS CDO 2007-1 Ltd., 452 B.R. 31 (Bankr. S.D.N.Y. 2011). In this case, however, Bankruptcy Judge Shelley C. Chapman disagreed, concluding, inter alia, that even assuming the flip provisions should be treated as ipso facto clauses, they were nonetheless enforceable under the section 560 safe harbor. Lehman Bros. Special Fin. Inc. v. Bank of Am. Nat’l Ass’n (553 B.R. 476 (Bankr. S.D.N.Y. 2016)). On appeal, District Judge Lorna G. Schofield affirmed that ruling. 2018 WL 1322225 (S.D.N.Y. Mar. 14, 2018). LBSF again appealed, and on August 11, 2020, a Second Circuit panel affirmed in a per curiam opinion. 2020 WL 4590247 (2d Cir. Aug. 11, 2020).

The Second Circuit began its analysis by noting the safe harbor’s purpose when enacted in 1990—“to protect the stability of swap markets and to ensure that swap markets are not destabilized by uncertainties regarding the treatment of their financial instruments under the Bankruptcy Code,” id. at *5 (internal quotation marks omitted)—as well as a 2005 amendment that broadened the definition of “swap agreement” to include virtually all derivatives. Against that background, the court of appeals readily rejected LBSF’s arguments against the safe harbor’s application.

First, even though the flip clauses were set forth in indentures (as opposed to the swap agreements themselves), the court held the provisions were sufficiently incorporated into the swap agreements by reference. Second, the court held that section 560’s reference to “liquidation” was broad enough to encompass the distribution of collateral under the flip clauses. Third, the court deemed it irrelevant for purposes of the safe harbor that indenture trustees (as opposed to the noteholders themselves) were the parties that exercised the right to liquidate.

For these reasons, the court held that the safe harbor protected the distributions pursuant to the flip clauses. Although the Court grounded its holding primarily on the statutory text and features of the synthetic CDO transactions at issue, it noted that its conclusion was consistent with section 560’s legislative history, which reflects Congress’s intent “to protect a swap participant’s ability to unwind the swap transaction” and concerns about protecting market stability. Id. at *7. In that regard, this holding is consistent with Second Circuit decisions interpreting other bankruptcy safe harbor provisions broadly in order to minimize the risk of market disruption. See, e.g., In re Tribune Co. Fraudulent Conveyance Litig, 946 F.3d 66, 92 (2d Cir. 2019).

This ruling may bring to an end a 12-year saga that has played out before numerous judges in the U.S. and England (UK Supreme Court Upholds “Flip” Clauses). Unless LBSF obtains further review from the Second Circuit en banc or the U.S. Supreme Court, all courts within the Second Circuit must treat flip clauses in CDO transactions like these as enforceable under the section 560 safe harbor. More broadly, this ruling reinforces the deference courts provide to safe-harbored agreements and the provisions of those agreements. Parties should generally expect courts to continue granting wide protections to non-debtor counter-parties in safe-harbored transactions.